Thursday, May 9, 2013

Will margin debt cause the next stock market crash?

The
latest fear on Wall Street is that record levels of margin debt may end up
toppling the stock market rally.

NYSE
margin debt recently reached its highest level since 2007 before the last major
stock market peak and credit crash. Stephen Suttmeier, technical research
analyst at Bank of America, noted that margin debt, rose 28% in March
from a year ago to $380 billion. That figure is slightly below the July 2007
peak of $381 billion, although analysts speculate that April’s margin debt
totals (which haven’t yet been released) have already surpassed this mark.

Suttmeier told The Wall Street Journal that the currently high margin debt levels
are “contrarian bearish.” While high margin
levels have coincided with major market tops of the past, there’s an important
twist to this particular indicator. In
order to confirm that a top has been made, margin debt levels normally turn
down before major indices like the S&P 500 peak. See the following graph, courtesy BoA Merrill
Lynch.

“It’s no surprise people have been taking on more
risk as the market has moved to record highs,” writes Steven Russolillo in The Wall Street Journal. “But the question is what happens
when the easy ride higher turns south and some of that margin debt turns into
margin calls?” The article
goes on to warn of a potential selling wave if stock prices reverse and margin
calls lead to mass liquidation. “A wave
of margin calls can worsen selling pressure on stocks and was seen as partly to
blame for the market’s woes during the financial crisis,” writes Russolillo.

While it’s true that rising margin debt levels
should be viewed as a potential yellow flag for the stock market, other
indicators don’t yet suggest the rally has reached bubble proportions. As economist Ed Yardeni pointed out in a
recent blog (http://blog.yardeni.com), “Valuation multiples aren’t flashing
irrational exuberance yet, but that could change quickly in a debt-financed
melt-up of stock prices.”

Yardeni suggests that while NYSE margin
requirements have been unchanged since January 1974, Fed Chairman Bernanke
could boost the requirement later this year in response to charges that the Fed’s
stimulus program is leading to a stock market bubble.

Lest investors forget, margin requirement hikes
can take a huge toll on investor psychology and can completely take the wind
out of a market’s sails.Remember the
gold and silver margin increases of 2011, anyone?